UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1998
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
AND EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 0-24363
Interplay Entertainment Corp.
(Exact name of the registrant as specified in its charter)
Delaware 33-0102707
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
16815 Von Karman Avenue, Irvine, California 92606
(Address of principal executive offices)
(949) 553-6655
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [_] No [X]
State the number of shares outstanding of each of the issuer's classes of common
equity as of the latest practicable date.
Class Issued and Outstanding at November 20, 1998
----- -------------------------------------------
Common Stock, $0.001 par value 18,236,329
INTERPLAY ENTERTAINMENT CORP.
INDEX TO FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1998
Page
Number
------
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September
30, 1998 (unaudited) and December 31, 1997 3
Unaudited Condensed Consolidated Statements of
Operations for the three-month and nine-month periods
ended September 30, 1998 and 1997 4
Unaudited Condensed Consolidated Statements of
Stockholders' Equity (Deficit) as of September 30,
1998 (unaudited) and December 31, 1997 5
Unaudited Condensed Consolidated Statements of Cash
Flows for the nine-month periods ended September 30,
1998 and 1997 6
Notes to Unaudited Condensed Consolidated Financial
Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Part II. Other Information
Item 1. Legal Proceedings 31
Item 2. Exhibits and Reports on Form 8-K 31
Signatures 32
Exhibit Index 33
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
--------------------
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share data)
September 30, December 31,
1998 1997
------------- ------------
(unaudited)
ASSETS
------
Current Assets:
Cash and cash equivalents $ 1,230 $ 1,536
Trade receivables, net of allowances of $11,455
and $14,461, at Sept. 30, 1998 and Dec. 31,
1997 respectively 45,294 34,684
Inventories 5,821 6,338
Prepaid licenses and royalties 18,078 12,628
Income taxes receivable -- 1,427
Deferred income taxes 7,477 7,792
Other 4,766 4,218
-------- --------
Total current assets 82,666 68,623
-------- --------
Property and Equipment, net 6,205 7,026
-------- --------
Other Assets 1,891 2,172
-------- --------
$ 90,762 $ 77,821
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
Current Liabilities:
Accounts payable $ 23,838 $ 17,121
Accrued expenses and other expenses 19,772 22,549
Current portion of long-term debt 25,464 14,767
Income taxes payable 254 570
-------- --------
Total current liabilities 69,328 55,007
-------- --------
Long-Term Debt, net of current portion 205 23,387
-------- --------
Deferred Income Taxes 725 434
-------- --------
Minority Interest 178 260
-------- --------
Commitments and Contingencies
Stockholders' Equity (Deficit):
Preferred stock, $.001 par value--
Authorized--5,000,000 shares
Issued and outstanding--none -- --
Common stock, $.001 par value--
Authorized 50,000,000 shares
Issued and outstanding--18,236,329
and 10,951,828, respectively 18 11
Paid-in Capital 51,472 18,408
Retained earnings (accumulated deficit) (31,468) (19,877)
Cumulative translation adjustment 304 191
-------- --------
Total stockholders' equity (deficit) 20,326 (1,267)
-------- --------
$ 90,762 $ 77,821
======== ========
The accompanying notes are an integral part
of these condensed consolidated financial statements.
3
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except share and per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
Net revenues $ 24,504 $ 23,833 $ 106,225 $ 66,745
Cost of goods sold 19,141 14,153 58,653 41,602
---------- ---------- ---------- ----------
Gross profit 5,363 9,680 47,572 25,143
---------- ---------- ---------- ----------
Operating expenses:
Marketing and sales 9,797 5,851 27,411 19,085
General and administrative 3,739 2,948 9,516 10,050
Product development 6,615 5,312 18,555 16,616
---------- ---------- ---------- ----------
Total operating expenses 20,151 14,111 55,482 45,751
Operating loss (14,788) (4,431) (7,910) (20,608)
Interest and other expense (811) (1,050) (3,673) (2,088)
---------- ---------- ---------- ----------
Loss before income taxes (15,599) (5,481) (11,583) (22,696)
Provision (benefit) for income taxes (468) -- 8 (1,782)
---------- ---------- ---------- ----------
Net loss $ (15,131) $ (5,481) $ (11,591) $ (20,914)
========== ========== ========== ==========
Net loss per share:
Basic and diluted $ (0.83) $ (0.49) $ (0.85) $ (1.88)
========== ========== ========== ==========
Weighted average number of
common shares outstanding:
Basic and diluted 18,230,673 11,130,422 13,591,820 11,125,795
========== ========== ========== ==========
The accompanying notes are an integral part
of these condensed consolidated financial statements.
4
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(amounts in thousands, except share data)
Common Stock Retained Cumulative
------------------ Paid-in Earnings Translation
Shares Amount Capital (Deficit) Adjustment Total
---------- ------ ------- --------- ----------- ---------
Balance, December 31, 1997 10,951,828 $11 $18,408 $(19,877) $191 $ (1,267)
Issuance of common stock 1,200 -- 10 -- -- 10
Compensation for stock options granted -- -- 76 -- -- 76
Net income -- -- -- 2,849 -- 2,849
Translation adjustment -- -- -- -- 1 1
---------- --- ------- -------- ---- --------
Balance, March 31, 1998 (unaudited) 10,953,028 11 18,494 (17,028) 192 1,669
Issuance of common stock 5,000,000 5 24,673 -- -- 24,678
Compensation for stock options granted -- -- 42 -- -- 42
Exercise of warrants 2,272,417 2 8,581 -- -- 8,583
Net income -- -- -- 691 -- 691
Translation adjustment -- -- -- -- (1) (1)
---------- --- ------- -------- ---- --------
Balance, June 30, 1998 (unaudited) 18,225,445 18 51,790 (16,337) 191 35,662
Compensation for stock options granted -- -- 16 -- -- 16
Exercise of options 10,884 -- 5 -- -- 5
Common stock issuance costs -- -- (339) -- -- (339)
Net income -- -- -- (15,131) -- (15,131)
Translation adjustment -- -- -- -- 113 113
---------- --- ------- -------- ---- --------
Balance, September 30, 1998 (unaudited) 18,236,329 $18 $51,472 $(31,468) $304 $ 20,326
========== === ======= ======== ==== ========
The accompanying notes are an integral part of
these condensed consolidated financial statements.
5
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)
Nine Months
Ended September 30,
--------------------
1998 1997
--------- ---------
Cash flows from operating activities:
Net income (loss) $(11,591) $(20,914)
Adjustments to reconcile net income (loss) to the
cash provided by (used in) operating activities--
Depreciation and amortization 2,634 2,273
Noncash expense for stock options 134 230
Deferred income taxes 606 --
Minority interest in earnings (loss) of subsidiary (82) --
Changes in assets and liabilities:
Trade receivables (10,605) 3,573
Inventories 517 2,466
Income taxes receivable 1,427 --
Other current assets (548) 250
Other assets (5) (1,094)
Prepaid licenses and royalties (5,450) 2,066
Accounts payable 6,717 (6,052)
Accrued expenses (2,777) 8,153
Income taxes payable (316) 243
-------- --------
Net cash used in operating activities (19,339) (8,806)
-------- --------
Cash flows from investing activities:
Purchase of property and equipment (1,527) (1,330)
-------- --------
Net cash used in investing activities (1,527) (1,330)
-------- --------
Cash flows from financing activities:
Net borrowings on line of credit 1,956 6,084
Issuance of Subordinated Secured Promissory Notes
and Warrants -- 1,573
Repayment of Subordinated Secured Promissory Notes
and Warrants (6,072) --
Net proceeds from issuance of common stock 24,349 --
Other financing 214 204
-------- --------
Net cash provided by financing activities 20,447 7,861
-------- --------
Effect of exchange rate changes on cash and cash
equivalents 113 --
-------- --------
Net decrease in cash and cash equivalents (306) (2,275)
Cash and cash equivalents, beginning of year 1,536 3,135
-------- --------
Cash and cash equivalents, end of year $ 1,230 $ 860
======== ========
Supplemental cash flow information:
Cash paid during the period for:
Interest $ 3,659 $ 2,294
======== ========
Income taxes $ 3 $ --
======== ========
The accompanying notes are an integral part of
these condensed consolidated financial statements.
6
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Amounts and disclosures as of September 30, 1998 and 1997 and for
each of the periods then ended are unaudited
(amounts in thousands, except share and per share data)
Note 1. Basis of Presentation
The accompanying interim condensed consolidated financial statements of
Interplay Entertainment Corp. and its subsidiaries (the "Company") are unaudited
and reflect all adjustments (consisting only of normal recurring accruals) that,
in the opinion of management, are necessary for a fair presentation of the
results for the interim period in accordance with instructions for Form 10-Q.
Accordingly, they do not include all information and footnotes required by
generally accepted accounting principles for complete financial statements. The
results of operations for the current interim period are not necessarily
indicative of results to be expected for the current year or any other period.
These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto for the
eight month period ended December 31, 1997 included in the Final Prospectus
dated June 19, 1998 which was part of the Company's Registration Statement on
Form S-1 as amended (Registration Number 333-48473) as filed with the Securities
and Exchange Commission.
Reclassifications
Certain reclassifications have been made to the prior year's financial
statements to conform to classifications used in the current period.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 130 "Reporting Comprehensive Income"
effective for fiscal years beginning after December 15, 1998, which establishes
standards for reporting and display of comprehensive income and its components
in a full set of general purpose financial statements. Effective January 1,
1998 the Company adopted SFAS No. 130. Comprehensive income for the Company
would include the impact of foreign currency translation adjustments which were
immaterial for the periods reported including the three month period ended
September 30, 1998 for which the impact of foreign currency adjustments were
$113,000.
Revenue Recognition
Revenues are recorded when products are delivered to customers in accordance
with Statement of Position (SOP) 91-1, Software Revenue Recognition. For those
agreements that provide the customers the right to multiple copies in exchange
for guaranteed amounts, revenue is recognized at the delivery of the product
master or the first copy. Per copy royalties on sales that exceed the guarantee
are recognized as earned. The Company is generally not contractually obligated
to accept returns, except for defective product. However, the Company permits
customers to return or exchange product and may provide price protection on
products unsold by a customer. In accordance with SFAS No. 48, revenue is
recorded net of allowance for estimated returns, exchanges, markdowns, price
concessions, and warranty costs. Such reserves are based upon management's
evaluation of historical experience, current industry trends and estimated
costs. The amount of reserves ultimately required could differ materially in
the near term from the amounts included in the accompanying consolidated
financial statements. Postcontract customer support provided by the Company is
limited to telephone support. These costs are not material and are charged to
expenses as incurred.
7
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Amounts and disclosures as of September 30, 1998 and 1997 and for
each of the periods then ended are unaudited
(amounts in thousands, except share and per share data)
Note 2. Prepaid Licenses and Royalties
Prepaid licenses and royalties consist of payments for intellectual property
rights, payments to celebrities and sports leagues and advanced royalty payments
to outside developers. In addition, such costs include certain other outside
production costs generally consisting of film cost and amounts paid for
digitized motion data with alternative future uses. Payments to developers
represent contractual advance payments made for future royalties. These
payments are contingent upon the successful completion of milestones, which
generally represent specific deliverables. Royalty advances are generally
recoupable against future sales based upon the contractual royalty rate. The
Company amortizes the cost of licenses, prepaid royalties and other outside
production costs to cost of goods sold over six months commencing with the
initial shipment of the title at a rate based upon the number of units shipped.
Management evaluates the future realization of such costs quarterly and charges
to cost of goods sold any amounts that management deems unlikely to be fully
realized through future sales. Such costs are classified as current and
noncurrent assets based upon estimated net product sales.
Note 3. Inventories
Inventories consist of the following:
September 30, December 31,
1998 1997
------------- ------------
Packaged software $3,595 $4,171
CD-ROMs, cartridges, manuals, packaging and supplies 2,226 2,167
------ ------
$5,821 $6,338
====== ======
8
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Amounts and disclosures as of September 30, 1998 and 1997 and for
each of the periods then ended are unaudited
(amounts in thousands, except share and per share data)
Note 4. Long-Term Debt
Long-term debt consists of the following:
September 30, December 31,
1998 1997
------------- ------------
Subordinated Secured Promissory Notes $ - $ 14,655
Loan Agreement 25,202 23,246
Other 467 253
-------- --------
25,669 38,154
Less--current portion (25,464) (14,767)
-------- --------
$ 205 $ 23,387
======== ========
Subordinated Secured Promissory Notes
From October 1996 through February 1997, the Company issued $14,803 in
Subordinated Secured Promissory Notes ("Notes") and nondetachable Warrants to
purchase Common Stock, of which employees, officers, and directors of the
Company held $2,600 of the total Notes outstanding. The principal amount of the
Notes was $14,655 and the purchase price of the Warrants was $148. The amount
paid for the Warrants approximates management's estimate of the fair market
value of the Warrants at the date of issuance and is included in paid-in capital
in the accompanying condensed consolidated balance sheets. The Notes provided
for interest at a rate of 12.0 percent per year, payable quarterly, beginning
May 1, 1997. Interest expense related to the Notes was $866 for the nine months
ended September 30, 1998.
Each Warrant holder had the right to purchase from the Company the number of
shares of Common Stock equal to the investor's aggregate investment (including
Notes and Warrants) divided by the product of 0.70 multiplied by (a) the initial
public offering ("IPO") price per share or (b) in the event of a Sales
Transaction, the fair market value per share as determined in the Sales
Transaction.
In accordance with the terms of the Notes, the Company requested that each
holder elect to either convert the outstanding principal amount to Common Stock
upon the closing of the IPO or receive full payment in cash from the proceeds of
the IPO. At the IPO completion, the holders of approximately $8,748 of Notes
and Warrants elected to exercise their Warrants by converting their Notes to
Common Stock. Remaining Note holders with a balance of approximately $6,349
requested payment in cash inclusive of interest of $277 which amount of
principal and interest was paid by the Company in July 1998.
9
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Amounts and disclosures as of September 30, 1998 and 1997 and for
each of the periods then ended are unaudited
(amounts in thousands, except share and per share data)
Loan Agreement
In June 1997, the Company entered into a Loan and Security Agreement (Loan
Agreement) with a financial institution which was amended in February 1998.
Borrowings under the Loan Agreement bear interest at LIBOR (5.72 percent at
December 31, 1997 and 5.69 percent at September 30, 1998) plus 4.87 percent
(10.59 percent at December 31, 1997 and 10.56 percent at September 30, 1998).
The agreement provides for a line of credit based in part on qualified
receivables and inventory. Borrowings under this Loan Agreement may be up to a
maximum of $35,000 through August 30, 1998; $30,000 from August 31 to December
30, 1998; and $25,000 thereafter. Within the total credit limits, the Company
may borrow up to $10,000 in excess of its borrowing base through August 1998 and
up to $5,000 in excess of its borrowing base thereafter through December 30,
1998. The line of credit is secured by cash, accounts receivable and inventory
and by a security interest in certain of the Company's assets and expires May
31, 1999. The line of credit became a current liability in June 1998. See Note
7.
Note 5. Net Loss Per Share
Basic net loss per share is computed by dividing loss available to common
stockholders by the weighted average number of common shares outstanding.
Diluted net loss per share is computed by dividing loss available to common
stockholders by the weighted average number of common shares outstanding plus
the effect of any dilutive stock options and Common Stock Warrants using the
treasury stock method. The following table summarizes the computation of Basic
and Diluted net loss per share:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- -------------------------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
Basic EPS Computation:
Net loss $ (15,131) $ (5,481) $ (11,591) $ (20,914)
Weighted average common shares outstanding 18,230,673 11,130,422 13,591,820 11,125,795
Basic net loss per share $ (0.83) $ (0.49) $ (0.85) $ (1.88)
Diluted EPS Computation:
Net loss $ (15,131) $ (5,481) $ (11,591) $ (20,914)
Adjustments to net loss -- $ -- $ -- $ --
----------- ----------- ----------- -----------
Diluted net loss $ (15,131) $ (5,481) $ (11,591) $ (20,914)
Weighted average common shares outstanding 18,230,673 11,130,422 13,591,820 11,125,795
Stock Options, Subordinated Notes and Warrants -- -- -- --
----------- ----------- ----------- -----------
Diluted common shares outstanding 18,230,673 11,130,422 13,591,820 11,125,795
Diluted net loss per share $ (0.83) $ (0.49) $ (0.85) $ (1.88)
10
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Amounts and disclosures as of September 30, 1998 and 1997 and for
each of the periods then ended are unaudited
(amounts in thousands, except share and per share data)
Note 6. Initial Public Offering
The Company effected a registration with the Securities and Exchange
Commission on Form S-1, Registration No. 333-48473 (the "Registration
Statement"), whereby the Company registered up to 5,750,000 shares of its Common
Stock. On June 18, 1998 the Registration Statement was declared effective by
the Securities and Exchange Commission. On June 24, 1998, the Company completed
its initial public offering of 5,000,000 shares of Common Stock, at $5.50 per
share, that raised approximately $24,236, net of expenses of $3,264. In
addition, in connection with the offering, 750,000 shares of Common Stock of the
Company were sold by a selling stockholder at $5.50 per share, for which the
company received no proceeds. An adjustment was made in the quarter ended
September 30, 1998 for $339 in registration costs incurred in connection with
the initial public offering in excess of costs recognized in the quarter ended
June 30, 1998.
Note 7. Subsequent Event
In November 1998, the Company amended its line of credit with a financial
institution to provide for a $37.5 million maximum credit limit through May 31,
1999, based in part on qualifying receivables and inventory. Within the total
credit limit, the Company may borrow up to $14.0 million in excess of its
borrowing base through May 31, 1999. Under the amended line of credit, the
Company is required to deposit with the financial institution cash collateral of
$1.0 million on each of February 15, March 15 and April 15, 1999, which will
effectively reduce the total amounts available for borrowing under the line to
$36.5 million as of February 15, 1999, $35.5 million as of March 15, 1999 and
$34.5 million as of April 15, 1999. The amended line of credit also provides for
a personal guarantee by the Company's Chairman and Chief Executive Officer,
Brian Fargo, in the amount of $5.0 million secured by certain of Mr. Fargo's
personal assets. As consideration for making such guarantee, Mr. Fargo is
receiving warrants to purchase 400,000 shares of the Company's Common Stock (the
"Warrants") at an exercise price of $3.00 per share. The Warrants have a three
year term and include a cashless exercise provision but Mr. Fargo will not have
registration rights with respect to the shares issuable upon exercise of the
Warrants. In addition, the Warrants are not exercisable in the event the Company
enters into an agreement to merge or combine the Company within six months after
the issuance date of the Warrants. The shares issuable upon exercise of the
Warrants are subject to the twelve month lockup agreement Mr. Fargo entered into
in connection with the Company's initial public offering. In connection with the
issuance of the Warrants, the Company is required to record an expense equal to
the fair market value of the Warrants, which is estimated to be approximately
$0.3 million, with such expense being amortized as additional debt cost over the
term of the guarantee. In addition, the issuance of such Warrants by the Company
may result in dilution to stockholders. The line of credit expires May 31, 1999.
Based upon certain assumptions, including without limitation, the Company's
ability to achieve anticipated operating results. The Company believes that it
will be able to renew its line of credit or obtain alternate financing on
reasonable terms. However, there can be no assurance that the assumptions relied
on by the Company will prove correct or that the Company will be able to renew
or replace its line of credit or obtain alternate financing on reasonable terms,
if at all. The Company is currently in compliance with the terms of its line of
credit.
In November 1998, the Company entered into certain product license and
distribution agreements which in the aggregate provide for the Company to
receive approximately $9.7 million over the next ninety days.
The Company believes that funds available under its line of credit, amounts to
be received under various product license and distribution agreements and
anticipated funds from operations, if any, will be sufficient to satisfy the
Company's projected working capital and capital expenditure needs and debt
obligations in the normal course of business at least through the expiration of
its line on May 31, 1999. Based upon certain assumptions, including without
limitation, the Company's ability to achieve anticipated operating results, the
Company believes that it will be able to renew its line of credit or obtain
alternate financing on reasonable terms. However, there can be no assurance that
the assumptions relied on by the Comapny will prove correct or the Company will
be able to renew or replace its line of credit on satisfactory terms, if at all.
Further, and there can be no assurance that the Company will not be required to
raise additional working capital through debt or equity financing during such
period. If the Company is required to raise additional working capital, there
can be no assurance that the Company will be able to raise such additional
working capital on acceptable terms, if at all. The issuance of additional debt
securities would likely result in significant additional interest expense, and
the issuance of additional equity securities would likely result in material
dilution to stockholders. In the event the Company is unable to renew its line
of credit or raise additional working capital, further measures would be
necessary including, without limitation, the sale or consolidation of certain
operations, the delay, cancellation or scale back of product development and
marketing programs and other actions. No assurance can be given that such
measures would not materially adversely affect the Company's ability to develop
and publish commercially viable titles and compete effectively in its markets,
or that such measures would be sufficient to generate operating profits in
fiscal 1998 and beyond or would not negatively impact the Company's operating
results in future periods. Certain of such measures may require third party
consents or approvals, including the Company's bank, and there can be no such
assurance that such consents or approvals can be obtained.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
-----------------------------------------------------------------------
of Operations
-------------
Cautionary Statement
This Form 10-Q contains certain forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
and Exchange Act of 1934 and such forward-looking statements are subject to the
safe harbors created thereby. For this purpose, any statements contained in
this Form 10-Q except for historical information may be deemed to be forward-
looking statements. Without limiting the generality of the foregoing, words
such as "may," "will," "expect," "believe," "anticipate," "intend," "could,"
"estimate" or "continue" or the negative or other variations thereof or
comparable terminology are intended to identify forward-looking statements. In
addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking
statements.
The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties, as well as on
certain assumptions. For example, any statements regarding future cash flow,
financing activities, cost reduction measures, compliance with the Company's
line of credit and an extension or replacement of such line are forward-looking
statements and there can be no assurance that the Company will generate positive
cash flow in the future or that the Company will be able to obtain financing on
satisfactory terms, if at all, or that any cost reductions effected by the
Company will be sufficient to offset any negative cash flow from operations or
that the Company will remain in compliance with its line of credit or be able to
renew or replace such line. Additional risks and uncertainties include possible
delays in the completion of products, the possible lack of consumer appeal and
acceptance of products released by the Company, fluctuations in demand, lost
sales because of the rescheduling of products launched or orders delivered, that
the Company's markets will continue to grow, that the Company's products will
remain accepted within their respective markets, that competitive conditions
within the Company's markets will not change materially or adversely, that the
Company will retain key development and management personnel, that the Company's
forecasts will accurately anticipate market demand, that there will be no
material adverse change in the Company's operations or business. Additional
factors that may affect future operating results are discussed in more detail in
"Certain Factors that May Affect the Company's Business and Future Results,"
below as well as in the final Prospectus dated June 19, 1998 which is included
in the Company's Registration Statement on Form S-1 as amended (Registration
Number 333-48473) on file with the Securities and Exchange Commission.
Assumptions relating to the foregoing involve judgments with respect to, among
other things, future economic, competitive and market conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking statements
are reasonable, the business and operations of the Company are subject to
substantial risks that increase the uncertainty inherent in the forward-looking
statements, and the inclusion of such information should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. In addition, risks, uncertainties and
assumptions change as events or circumstances change. The Company disclaims any
obligation to publicly release the results of any revisions to these forward-
looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this Form 10-Q with the SEC or otherwise
to revise or update any oral or written forward-looking statement that may be
made from time to time by or on behalf of the Company.
The information contained in this Form 10-Q is not a complete description of
the Company's business or the risks associated with an investment in the
Company. Readers are urged to carefully review and consider the various
disclosures made by the Company in this Report and in the Company's
12
other filings with the SEC, including its Final Prospectus, that attempt to
advise interested parties of certain risks, uncertainties and other factors that
may affect the Company's business.
General
The Company commenced operations in 1983, and operated as an independent
development studio until 1988, creating interactive entertainment software games
for publishers such as Electronic Arts and Activision. In 1988, the Company
began publishing software through an affiliate label relationship with
Activision, pursuant to which Activision distributed the Company's software in
North America. The Company began publishing and distributing its own
interactive entertainment software for both PCs and video game consoles in 1992
and has continued to build its publishing and distribution infrastructure since
that date. In addition to developing products through its internal product
development group, the Company publishes titles developed by third party
interactive entertainment software developers.
The Company derives net revenues primarily from direct sales of interactive
entertainment software for PCs and video game consoles to retailers and mass
merchants, from indirect sales to software distributors in North America and
internationally, from the distribution by the Company on an affiliate label
basis of titles published by third parties, and from direct sales to end-users
through the Company's catalogs and the Internet. The Company also derives
royalty-based revenues from licensing arrangements, from the sale of products by
third party distributors in international markets, and from OEM bundling
transactions.
The Company recognizes net revenues from the sale of its products upon
shipment. Subject to certain limitations, the Company permits customers to
obtain exchanges within certain specified periods and provides price protection
on certain unsold merchandise. Net revenues from product sales are reflected
after deducting an allowance for returns, markdowns and price protection. With
respect to license agreements which provide customers the right to multiple
copies in exchange for guaranteed amounts, net revenues are recognized upon
delivery of the product master or the first copy as long as no other significant
vendor obligations exist. Per copy royalties on sales which exceed the
guarantee are recognized as earned.
In order to expand the Company's distribution channels and engage in software
development in overseas markets, in 1995 the Company established operations in
the United Kingdom and in Japan. In July 1997, the Company initiated a
licensing strategy in Japan and terminated its operations there.
In January 1997, the Company formed a wholly owned subsidiary, Interplay OEM,
Inc. ("Interplay OEM"), which had previously operated as a division of the
Company. Interplay OEM distributes the Company's interactive entertainment
software titles, as well as those of other software publishers, to computer
hardware and peripheral device manufacturers for use in bundling arrangements.
The Company also derives net revenues from the licensing of certain of its
intellectual properties and certain of its products to third parties for
distribution in markets through channels which are outside the Company's primary
focus. The Company expects that OEM, royalty and licensing net revenues may
decline, both in dollars and as a percentage of net revenues, as a larger
proportion of OEM, royalty and licensing net revenues are generated from
royalty-based licensing transactions, as opposed to the shipment of finished
goods, and as the OEM channel of distribution becomes more competitive.
Cost of goods sold related to PC and video games console net revenues
represents the manufacturing and related costs of interactive entertainment
software products, including costs of media, manuals, duplication, packaging
materials, assembly, freight and royalties paid to developers, licensors and
hardware manufacturers. Cost of goods sold related to royalty-based net
revenues primarily represent third party licensing fees and royalties paid by
the Company. Typically, cost of goods sold as a
13
percentage of net revenues for video game console products and affiliate label
products are higher than cost of goods sold as a percentage of net revenues for
PC based products due to the relatively higher manufacturing and royalty costs
associated with these products. Also included in the cost of goods sold is the
amortization of prepaid royalty and license fees paid to third party software
developers. Prepaid royalties are expensed over a period of six months from
initial shipment. The Company evaluates the likelihood of future realization of
prepaid royalties quarterly, on a product by product basis, and charges cost of
goods sold for any amounts that it deems unlikely to be realized through future
product sales.
Effective May 1, 1997, the Company changed its fiscal year end from April 30
to December 31.
The Company's operating results have fluctuated significantly in the past and
will likely fluctuate significantly in the future, both on a quarterly and an
annual basis. A number of factors may cause or contribute to such fluctuations,
and many of such factors are beyond the Company's control. There can be no
assurance that the Company will be profitable in any particular period. It is
likely that the Company's operating results in one or more future periods will
fail to meet or exceed the expectations of security analysts or investors.
Results of Operations
The following table sets forth certain selected condensed consolidated
statements of operations data, segment data and platform data for the periods
indicated in dollars and as a percentage of total net revenues:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------ ----------------------------------------------
1998 1997 1998 1997
-------------------- ------------------- ----------------------- --------------------
% of Net % of Net % of Net % of Net
Amount Revenues Amount Revenues Amount Revenues Amount Revenues
-------- -------- ------- -------- --------- -------- ------- ---------
Net revenues $ 24,504 100.0% $23,833 100.0% $ 106,225 100.0% $ 66,745 100.0%
Cost of goods sold 19,141 78.1% 14,153 59.4% 58,653 55.2% 41,602 62.3%
Gross profit 5,363 21.9% 9,680 40.6% 47,572 44.8% 25,143 37.7%
-------- -------- ------- -------- --------- -------- ------- ---------
Operating expenses:
Marketing and sales 9,797 40.0% 5,851 24.5% 27,411 25.8% 19,085 28.6%
General and administrative 3,739 15.2% 2,948 12.4% 9,516 9.0% 10,050 15.1%
Product development 6,615 27.0% 5,312 22.3% 18,555 17.4% 16,616 24.9%
Total operating expenses 20,151 82.2% 14,111 59.2% 55,482 52.2% 45,751 68.6%
-------- -------- ------- -------- --------- -------- ------- ---------
Operating loss (14,788) (60.3%) (4,431) (18.6%) (7,910) (7.4%) (20,608) (30.9%)
Interest and other expense (811) (3.3%) (1,050) (4.4%) (3,673) (3.5%) (2,088) (3.1%)
-------- -------- ------- -------- --------- -------- ------- ---------
Loss before income taxes (15,599) (63.6%) (5,481) (23.0%) (11,583) (10.9%) (22,696) (34.0%)
Provision (benefit) for income taxes (468) (1.9%) -- 0.0% 8 0.0% (1,782) (2.7%)
Net loss $(15,131) (61.7%) $(5,481) (23.0%) ($11,591) (10.9%) $(20,914) (31.3%)
======== ======== ======= ======== ========= ======== ======== =========
Net revenues by segment:
North America $ 15,472 63.1% $15,694 65.8% $ 63,379 59.6% $ 32,730 49.0%
International 7,035 28.7% 3,477 14.6% 28,337 26.7% 23,497 35.2%
OEM, royalty and licensing 1,997 8.2% 4,662 19.6% 14,509 13.7% 10,518 15.8%
-------- -------- ------- -------- --------- -------- ------- ---------
$ 24,504 100.0% $23,833 100.0% $ 106,225 100.0% $ 66,745 100.0%
======== ======== ======= ======== ========= ======== ======== =========
Net revenues by platform:
Personal computer $ 7,657 31.2% $16,295 68.3% $ 52,643 49.5% $ 42,235 63.2%
Video game console 14,850 60.6% 2,876 12.1% 39,073 36.8% 13,992 21.0%
OEM, royalty and licensing 1,997 8.2% 4,662 19.6% 14,509 13.7% 10,518 15.8%
-------- -------- ------- -------- --------- -------- ------- ---------
$ 24,504 100.0% $23,833 100.0% $ 106,225 100.0% $ 66,745 100.0%
======== ======== ======= ======== ========= ======== ======== =========
14
Net Revenues
Net revenues for the three months ended September 30, 1998 increased 2.8% to
$24.5 million from $23.8 million in the comparable 1997 quarter. North America
net revenues decreased slightly to $15.5 million, or 63.1% of net revenues, from
$15.7 million, or 65.8% of net revenues, in the 1997 quarter. International net
revenues increased to $7.0 million, or 28.7% of net revenues, from $3.5 million,
or 14.6% of net revenues in the 1997 quarter. OEM, royalty and licensing net
revenues decreased to $2.0 million, or 8.2% of net revenues, in the 1998 quarter
from $4.7 million, or 19.6% of net revenues, in the 1997 quarter.
Net revenues for the nine months ended September 30, 1998 increased 59.2% to
$106.2 million from $66.7 million in the comparable 1997 period. North America
net revenues increased to $63.4 million, or 59.6% of net revenues from $32.7
million, or 49.0% of net revenues, in the 1997 period. International net
revenues increased to $28.3 million, or 26.7% of net revenues, from $23.5
million, or 35.2% of net revenues, in the 1997 period. OEM, royalty and
licensing net revenues increased to $14.5 million, or 13.7% of net revenues, in
the 1998 period from $10.5 million, or 15.8% of net revenues, in the 1997
period.
The moderate increase in net revenues for the three months ended September 30,
1998 was primarily due to increased title releases offset by a high level of
product returns and markdowns. The increase in net revenues for the nine months
ended September 30, 1998 was primarily due to increased title releases across
multiple platforms and resulting increases in unit sales volume in the 1998
periods, including significant title releases, such as Caesars Palace II
(PlayStation), Crime Killer (PlayStation), Die By The Sword (PC), Descent:
Freespace The Great War (PC), Heart of Darkness (PlayStation), VR Sports
Powerboat Racing (PC and PlayStation), Redneck Deer Huntin' (PC), Redneck Rides
Again (PC), VR Baseball `99 (PlayStation), and Wild 9 (PlayStation). The
increase in international net revenues was due primarily to increased sales in
Europe offset in part by decreased sales in Asia. The Company expects that OEM,
royalty and licensing net revenues may continue to decline, both in dollars and
as a percentage of net revenues during the remainder of 1998 as a larger
proportion of OEM, royalty and licensing net revenues are generated from
royalty-based licensing transactions, as opposed to the shipment of finished
goods, and as such distribution channels become more competitive.
Cost of Goods Sold; Gross Margin
Cost of goods sold increased 35.2% in the three months ended September 30,
1998 to $19.1 million, or 78.1% of net revenues, from $14.2 million, or 59.4% of
net revenues in the comparable 1997 quarter. Gross margin decreased to 21.9% in
the 1998 quarter from 40.6% in the 1997 quarter.
Cost of goods sold increased 41.0% in the nine months ended September 30, 1998
to $58.7 million, or 55.2% of net revenues, from $41.6 million, or 62.3% of net
revenues, in the comparable 1997 period. Gross margin increased to 44.8% in the
1998 period from 37.7% in the 1997 period.
The decrease in gross margin during the three months ended September 30, 1998
was primarily a result of increased product returns and markdowns and the change
in the product mix from higher margin PC titles to lower margin console titles.
The increase in gross margin during the nine months ended September 30, 1998 was
primarily attributable to increased sales of certain higher margin PC products
during the period, offset in part by sales of video game console products, which
generally have lower margins. The 1997 periods also included the effects of
additional write-offs of prepaid royalties relating to titles or platform
versions of titles which had been canceled or which were expected to achieve
lower unit sales than were originally anticipated.
15
Operating Expenses
Total operating expenses increased 42.8% to $20.2 million, or 82.2% of net
revenues, in the three months ended September 30, 1998 from $14.1 million, or
59.2% of net revenues, for the comparable 1997 quarter. Total operating
expenses increased 21.3% to $55.5 million, or 52.2% of net revenues, in the nine
months ended September 30, 1998 from $45.8 million, or 68.6% of net revenues,
for the comparable 1997 period.
Marketing and Sales. Marketing and sales expenses primarily include
advertising and retail marketing support, sales commissions, marketing and sales
personnel, customer support services, fulfillment and other costs. Marketing
and sales expenses increased 67.4% to $9.8 million, or 40.0% of net revenues,
for the three months ended September 30, 1998 from $5.9 million, or 24.5% of net
revenues for the comparable 1997 quarter and increased 43.6% to $27.4 million,
or 25.8% of net revenues, for the nine months ended September 30, 1998 from
$19.1 million, or 28.6% of net revenues, for the comparable 1997 period. The
increases in absolute dollars were primarily attributable to increased
advertising and other marketing costs associated with the increase in major
titles launched and products sold during the 1998 period. The increase as a
percentage of net revenues for the three months ended September 30, 1998 was
primarily attributable to increased advertising and commissions on product
releases in the U.S. and the European markets. The decrease as a percentage of
net revenues for the nine months ended September 30, 1998 was primarily
attributable to operating efficiencies achieved as a result of the increased net
revenues base. The Company expects that in future periods marketing and sales
expenses in future periods will increase in absolute dollars, but may vary as a
percentage of net revenues.
General and Administrative. General and administrative expenses primarily
include administrative personnel expenses, facilities costs, professional
expenses and other overhead charges. General and administrative expenses
increased 26.8% to $3.7 million, or 15.2% of net revenues, in the three months
ended September 30, 1998 from $2.9 million, or 12.4% of net revenues in the
comparable 1997 quarter and decreased 5.3% to $9.5 million, or 9.0% of net
revenues, in the nine months ended September 30, 1998 from $10.1 million, or
15.1% of net revenues, in the comparable 1997 period. The increase in both
absolute dollars and as a percentage of net revenues in the three months ended
September 30, 1998 was primarily due to increased operations costs and the
provision for uncollectible amounts owed to the Company by Engage Games Online,
which is majority owned by the Company's Chairman and Chief Executive Officer.
The Company may in the future be required to make additional payments of
approximately $0.5 million in the aggregate under an equipment lease to which
the Company is a co-lessee with Engage, although the Company is attempting to
mitigate this expense by using or subleasing a portion of the equipment. The
decrease in absolute dollars in the nine months ended September 30, 1998 was
primarily attributable to lower overhead costs offset in part by increased
personnel and operations costs and facilities charges in North America and
Europe in support of increased net revenues. The decrease as a percentage of net
revenues in the nine months ended September 30, 1998 was primarily attributable
to operating efficiencies gained as a result of an increased net revenues base.
The Company expects that in future periods general and administrative expenses
will increase in absolute dollars, but may vary as a percentage of net revenues.
Product Development. Product development expenses, which primarily include
personnel and support costs, are charged to operations in the period incurred.
Product development expenses increased 24.5% to $6.6 million, or 27.0% of net
revenues, in the three month period ended September 30, 1998 from $5.3 million,
or 22.3% of net revenues, in the comparable 1997 quarter and increased 11.7% to
$18.6 million, or 17.4% of net revenues, in the nine months ended September 30,
1998 from $16.6 million, or 24.9% of net revenues, in the comparable 1997
period. The increases in absolute dollars were primarily due to the increase in
the number of products under development, offset in part by cost
16
efficiencies achieved as a result of the reorganization of the development
process. The increase as a percentage of net revenues in the three months ended
September 30, 1998 was primarily due to higher labor and operations costs
combined with a less than expected increase in net revenues base. The decrease
as a percentage of net revenues in the nine months ended September 30, 1998
primarily reflected cost savings and operating efficiencies gained as a result
of increased net revenues. The Company expects that in future periods product
development expenses will increase in absolute dollars, but may vary as a
percentage of net revenues.
Other Expense
Other expense for the three- and nine-month periods ended September 30, 1998
primarily included interest expense on the Company's bank line of credit and
Subordinated Secured Promissory Notes. Other expense decreased to $0.8 million
in the three months ended September 30, 1998 from $1.1 million in the comparable
1997 quarter and increased to $3.7 million in the nine months ended September
30, 1998 from $2.1 million in the comparable 1997 period. The decrease in the
three months ended September 30, 1998 was primarily due to decreased interest
expense resulting from the repayment of the Subordinated Secured Promissory
Notes and the reduction of the outstanding balance of the bank line of credit
from the proceeds of the IPO in June 1998. The increase in the nine months
ended September 30, 1998 was primarily due to increased borrowings under the
Company's line of credit to support increased working capital requirements prior
to completion of the IPO and interest on the Subordinated Secured Promissory
Notes.
Provision (Benefit) for Income Taxes
The Company recorded a tax benefit of $0.5 million in the three months ended
September 30, 1998, reversing the tax provision recorded earlier in the year
based on net income. No tax benefit was recorded in the 1997 quarter due to the
uncertainty of realization in future periods. The Company recorded a tax
provision of $0.01 million in the nine months ended September 30, 1998, compared
to a tax benefit of $1.8 million in the comparable 1997 period.
Liquidity and Capital Resources
The Company has funded its operations to date primarily through the use of
bank lines of credit and equipment leases, through cash generated by the private
sale of securities and from the proceeds from the initial public offering and
from operations. As of September 30, 1998 the Company's principal sources of
liquidity included cash and short term investments of approximately $1.2 million
and the Company's bank line of credit bearing interest at the London Interbank
Offered Rate plus 4.87% (10.56% as of September 30, 1998), expiring May 31,
1999. Under the terms of the bank line of credit as in effect on September 30,
1998, the Company had available borrowings and letters of credit up to $35.0
million through August 30, 1998, $30.0 million through December 30, 1998 and
$25.0 million through May 31, 1999, based in part upon qualifying receivables
and inventory. Within the overall credit limit, the line of credit as of
September 30, 1998 also provided that the Company could borrow up to $10.0
million in excess of its borrowing base through August 30, 1998 and up to $5.0
million in excess of its borrowing base through December 30, 1998. As of
September 30, 1998, the Company's balance on the bank line of credit was $25.2
million with stand by letters of credit outstanding totaling $4.6 million.
In November 1998, the Company amended its line of credit to provide for a
$37.5 million maximum credit limit through May 31, 1999, based in part upon
qualifying receivables and inventory. Within the total credit limit, the Company
may borrow up to $14.0 million in excess of its borrowing base through May 31,
1999. Under the amended line of credit, the Company is required to deposit with
the financial institution cash collateral of $1.0 million on each of February
15, March 15 and April 15, 1999, which will effectively require the Company to
reduce the total amounts outstanding under the line to $36.5 million as of
February 15, 1999, $35.5 million as of March 15, 1999 and $34.5 million as of
April 15, 1999. The amended line of credit also provides for a personal
guarantee by the Company's Chairman and Chief Executive Officer, Brian Fargo, in
the amount of $5 million secured by certain of Mr. Fargo's personal assets. As
consideration for making such guarantee, Mr. Fargo is receiving Warrants to
purchase
17
400,000 shares of the Company's Common Stock at an exercise price of $3.00 per
share. The Warrants have a three year term and include a cashless exercise
provision but Mr. Fargo will not have registration rights with respect to the
shares issuable upon exercise of the Warrants. In addition, the Warrants are not
exercisable in the event the Company enters into an agreement to merge or
combine the Company within six months after the issuance date of the Warrants.
The shares issuable upon exercise of the Warrants are subject to the twelve
month lockup agreement Mr. Fargo entered into in connection with the Company's
initial public offering. In connection with the issuance of the Warrants, the
Company is required to record an expense equal to the fair market value of the
Warrants, which is estimated to be approximately $0.3 million, with such expense
being amortized as additional debt cost over the term of the guarantee. In
addition, the issuance of such Warrants by the Company may result in dilution to
stockholders. The line of credit expires May 31, 1999. Based upon certain
assumptions, including without limitation, the Company's ability to achieve
anticipated operation results the Company believes that it will be able to
renew its line of credit or obtain alternate financing on reasonable terms.
However, there can be no assurance that the assumptions relied on by the Company
will prove correct or that the Company will be able to renew or replace its line
of credit or obtain alternate financing on reasonable terms, if at all. The
Company is currently in compliance with all terms of its credit agreement.
The Company's primary capital needs have historically been to fund working
capital requirements necessitated by its sales growth, the development and
introduction of products and related technologies and the acquisition or lease
of equipment and other assets used in the product development process. The
Company's operating activities used cash of $19.3 million during the nine months
ended September 30, 1998 and used $8.8 million during the nine months ended
September 30, 1997. The cash used by operating activities in the nine months
ended September 30, 1998 was primarily attributable to increased trade
receivables and the net loss in the period, offset in part by an increase in
accounts payable.
Cash provided by financing activities of $20.4 million in the nine months
ended September 30, 1998 resulted primarily from the proceeds from the Company's
initial public offering and by additions to borrowings under the Company's bank
line of credit. Cash provided by financing activities of $7.9 million in the
nine months ended September 30, 1997 resulted primarily from borrowings under
the Company's bank line of credit. On June 24, 1998 the Company completed its
initial public offering of 5,000,000 shares of Common Stock at $5.50 per share
which raised approximately $24.2 million, net of expenses. In connection with
the offering, $8.7 million of Notes and Warrants were converted to Common Stock
and $6.3 million were repaid in cash.
Cash used in investing activities of $1.5 million in the nine months ended
September 30, 1998 consisted of capital expenditures, primarily for office and
computer equipment used in Company operations. Cash used in investing
activities was $1.3 million in the nine months ended September 30, 1997
consisted of capital expenditures, primarily for office and computer equipment
used in Company operations. The Company does not currently have any material
commitments with respect to any capital expenditures.
The Company used net cash in operations of $7.6 million, $19.3 million and
$15.3 million, respectively, in the quarter ended September 30, 1998, the nine
months ended September 30, 1998 and the eight months ended December 31, 1997. To
provide liquidity, the Company has implemented certain measures including a
reduction of personnel, a decrease in management compensation and the delay,
cancellation or scale back of certain product development and marketing
programs, among other actions. In addition, the Company increased its line
of credit in November 1998 which line expires May 31, 1999. There can be no
assurance that the Company's operating expenses or current obligations will not
materially exceed cash flows available from the Company's operations in fiscal
1998 and beyond or that the increased line of credit will be sufficient to
finance any negative cash flow from operations or that such line of credit will
be renewed or replaced on reasonable terms, if at all. In addition, no assurance
can be given that the measures heretofore effected will not materially adversely
affect the Company's ability to develop and publish commercially viable titles,
or that such measures, whether alone or in conjunction with increased net
revenues, if any, will be sufficient to generate operating profits in fiscal
1998 and beyond. Certain of such measures may require third party consents or
approvals, including the Company's financial institution, and there can be no
such assurance that such consents or approvals can be obtained.
18
In November 1998, the Company entered into certain product license and
distribution agreements which in the aggregate provide for the Company to
receive approximately $9.7 million over the next ninety days.
The Company believes that funds available under its line of credit, amounts to
be received under various product license and distribution agreements and
anticipated funds from operations will be sufficient to satisfy the Company's
projected working capital and capital expenditure needs and debt obligations in
the normal course of business at least through the expiration of its line on May
31, 1999. Based upon certain assumptions, including without limitation, the
Company's ability to achieve anticipated operating results the Company believes
that it will be able to renew its line of credit or obtain alternate financing
on reasonable terms. However, there can be no assurance that the assumptions
relied on by the Company will prove correct or that the Company will be able to
renew or replace its line of credit on satisfactory terms, if at all. Further,
there can be no assurance that the Company will not be required to raise
additional working capital through debt or equity financing during such period.
If the Company is required to raise additional working capital, there can be no
assurance that the Company will be able to raise such additional working capital
on acceptable terms, if at all. In the event the Company is unable to raise
additional working capital, further measures would be necessary including,
without limitation, the sale or consolidation of certain operations, the delay,
cancellation or scale back of product development and marketing programs and
other actions. No assurance can be given that such measures would not materially
adversely affect the Company's ability to develop and publish commercially
viable titles, or that such measures would be sufficient to generate operating
profits in fiscal 1998 and beyond. Certain of such measures may require third
party consents or approvals, including the Company's financial institution, and
there can be no such assurance that such consents or approvals can be obtained.
Year 2000
See "Year 2000 Issue" in "Certain Factors That May Affect the Company's
Business and Future Results".
Certain Factors That May Affect the Company's Business and Future Results
In future periods the Company's business, financial condition and results of
operations may be affected in a material and adverse manner by many factors,
including, but not limited to, the following:
Liquidity; Future Capital Requirements
The Company used net cash in operations of $7.6 million, $19.3 million and
$15.3 million, respectively, in the quarter ended September 30, 1998, the nine
months ended September 30, 1998 and the eight months ended December 31, 1997.
There can be no assurance that the Company will ever generate positive cash flow
from operations. The Company's ability to fund its capital requirements out of
available cash, its line of credit and cash generated from operations will
depend on numerous factors, including the progress of the Company's product
development programs, the rate of growth of the Company's business, and the
commercial success of the Company's products. The Company may be required to
seek additional funds through debt or equity financings, product licensing or
distribution transactions or some other source of financing in order to provide
sufficient working capital for the Company for fiscal 1998 and beyond. The
issuance of additional equity securities by the Company could result in
substantial dilution to stockholders. If the Company is required to raise
additional working capital, there can be no assurance that the Company will be
able to raise such additional working capital on acceptable terms, if at all. In
the event the Company is unable to raise additional working capital, further
cost reduction measures would be necessary including, without limitation, the
sale or consolidation of certain operations, the delay, cancellation or scale
back of product development and marketing programs and other actions. No
assurance can be given that such measures would not materially adversely affect
the Company's ability to develop and publish commercially viable titles, or that
such measures would be sufficient to generate operating profits in fiscal 1998
and beyond. Certain of such measures may require third party approvals,
including the Company's financial institution, and there can be no assurance
that such consents or approvals can be obtained.
Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality
The Company's operating results have fluctuated significantly in the past and
will likely fluctuate significantly in the future, both on a quarterly and an
annual basis. A number of factors may cause or contribute to such fluctuations,
and many of such factors are beyond the Company's control. Such factors
include, but are not limited to, delays in shipment, demand for the Company's
and its competitors' products, the size and rate of growth of the market for
interactive entertainment software, changes in computing platforms, the number
of new products and product enhancements released by the Company and its
competitors during the period, changes in product mix, product returns, the
timing of orders placed by distributors and dealers, delays in shipment, the
timing of development and marketing expenditures, price competition and the
level of the Company's international and OEM, royalty and licensing net
revenues. The uncertainties associated with the interactive entertainment
software development process, lengthy manufacturing lead times for Nintendo-
compatible products, possible production delays, and the approval process for
products compatible with the Sony Computer Entertainment, Nintendo and Sega
video game consoles, as well as approvals required from other licensors, make it
difficult to accurately predict the quarter in which shipments will occur.
Because of
19
the limited number of products introduced by the Company in any particular
quarter, a delay in the introduction of a product may materially adversely
affect the Company's operating results for that quarter and may not be
recaptured in subsequent quarters. A significant portion of the Company's
operating expenses is relatively fixed, and planned expenditures are based
primarily on sales forecasts. If net revenues do not meet the Company's
expectations in any given quarter, operating results may be materially adversely
affected. The interactive entertainment software industry is highly seasonal,
with the highest levels of consumer demand occurring during the year-end holiday
buying season, followed by demand during the first calendar quarter. As a
result, net revenues, gross profits and operating income for the Company have
historically been highest during the fourth and the following first calendar
quarters, and have declined from those levels in subsequent second and third
calendar quarters.
The failure or inability of the Company to introduce products on a timely
basis to meet such seasonal increases in demand may have a material adverse
effect on the Company's business, operating results and financial condition.
The Company may over time become increasingly affected by the industry's
seasonal patterns. Although the Company seeks to reduce the effect of such
seasonal patterns on its business by distributing its product release dates more
evenly throughout the year, there can be no assurance that such efforts will be
successful. There can be no assurance that the Company will be profitable in
any particular period given the uncertainties associated with software
development, manufacturing, distribution and the impact of the industry's
seasonal patterns on the Company's net revenues.
As a result of the foregoing factors and the other factors discussed in
"Certain Factors that May Affect the Company's Business and Future Results," it
is likely that the Company's operating results in one or more future periods
will fail to meet or exceed the expectations of securities analysts or
investors. In such event, the trading price of the Common Stock would likely be
materially adversely affected.
Recent Losses
The Company has experienced significant losses in recent periods, including
losses of $11.6 million, $5.1 million, and $27.2 million, respectively, in the
nine months ended September 30, 1998, in the eight months ended December 31,
1997, and in the Company's former fiscal year ended April 30, 1997. The losses
for the nine months ended September 30, 1998 resulted primarily from delays in
the completion of certain products, a higher than expected level of product
returns and markdowns on products released during the quarter and in prior
periods and lower than expected worldwide sales of Wild 9. There can be no
assurance that the Company will not experience similar problems in current or
future periods or that the Company will be able to generate sufficient net
revenues or adequate working capital to attain or sustain profitability in the
future.
Dependence on New Product Introductions; Risk of Product Delays and Product
Defects
The Company's products typically have short life cycles, and the Company
depends on the timely introduction of successful new products, including
enhancements of or sequels to existing products and conversions of previously
released products to additional platforms, to generate net revenues to fund
operations and to replace declining net revenues from older products. In the
Company's quarter ended September 30, 1998, the Company's results of operations
were adversely affected by a number of factors, including delays in the
completion of certain new products including Fallout 2. If in the future for
any reason net revenues from new products were to fail to replace declining net
revenues from existing products, the Company's business, operating results and
financial condition could be materially adversely affected. The timing and
success of new interactive entertainment software product releases remains
unpredictable due to the complexity of product development, including the
uncertainty associated with new technology. The development cycle of new
products is difficult to predict but typically ranges from 12 to 24 months and
another six to 12 months for the porting of a product to a
20
different technology platform. In the past, the Company has frequently
experienced significant delays in the introduction of new products, including
certain products currently under development. Because net revenues associated
with the initial shipments of a new product generally constitute a high
percentage of the total net revenues associated with a product, any delay in the
introduction of, or the presence of a defect in, one or more new products
expected in a period could have a material adverse effect on the ultimate
success of such products and on the Company's business, operating results and
financial condition. The costs of developing and marketing new interactive
entertainment software have increased in recent years due to such factors as the
increasing complexity and content of interactive entertainment software,
increasing sophistication of hardware technology and consumer tastes and
increasing costs of obtaining licenses for intellectual properties, and the
Company expects this trend to continue. There can be no assurance that new
products will be introduced on schedule, if at all, or that, if introduced, they
will achieve significant market acceptance or generate significant net revenues.
In addition, software products as complex as those offered by the Company may
contain undetected errors when first introduced or when new versions are
released. There can be no assurance that, despite testing by the Company, errors
will not be found in new products or releases after commencement of commercial
shipments, resulting in loss of or delay in market acceptance, which could have
a material adverse effect on the Company's business, operating results and
financial condition.
Uncertainty of Market Acceptance; Dependence on Hit Titles
Consumer preferences for interactive entertainment software are continually
changing and are extremely difficult to predict. Historically, few interactive
entertainment software products have achieved sustained market acceptance.
Rather, a limited number of releases have become "hits" and have accounted for a
substantial portion of revenues in the industry. Further, publishers with a
history of producing hit titles have enjoyed a significant marketing advantage
because of their heightened brand recognition and consumer loyalty. The Company
expects the importance of introducing hit titles to increase in the future.
There can be no assurance that new products introduced by the Company will
achieve significant market acceptance, that such acceptance, if achieved, will
be sustainable for any significant period, or that product life cycles will be
sufficient to permit the Company to recover development and other associated
costs. Most of the Company's products have a relatively short life cycle and
sell for a limited period of time after their initial release, usually less than
one year. The Company believes that these trends will continue and that the
Company's future revenue will continue to be dependent on the successful
production of hit titles on a continuous basis. Because the Company introduces
a relatively limited number of new products in a given period, the failure of
one or more of such products to achieve market acceptance could have a material
adverse effect on the Company's business, operating results and financial
condition. Further, if market acceptance is not achieved, the Company could be
forced to accept substantial product returns or grant significant markdown
allowances to maintain its relationship with retailers and its access to
distribution channels. For example, the Company had higher than expected
product returns and markdowns in the quarter ended September 30, 1998 and there
can be no assurance that higher than expected product returns and markdowns will
not continue in the future. In the event that the Company is forced to accept
significant product returns or grant significant markdown allowances, its
business, operating results and financial condition could be materially
adversely affected.
Dependence on Third Party Software Developers
The Company relies on third party interactive entertainment software
developers for the development of a significant number of its interactive
entertainment software products. As reputable and competent third party
developers continue to be in high demand, there can be no assurance that third
party software developers that have developed products for the Company in the
past will continue to be available to develop products for the Company in the
future. Many third party software developers have limited financial resources,
which could expose the Company to the risk that such developers may go out
21
of business prior to completing a project. In addition, due to the limited
control that the Company exercises over third party software developers, there
can be no assurance that such developers will complete products for the Company
on a timely basis or within acceptable quality standards, if at all. Increased
competition for skilled third party software developers has required the Company
to enter into agreements with licensors of intellectual property and developers
of games that involved advance payments by the Company of royalties and
guaranteed minimum royalty payments, and the Company expects to continue to
enter into such arrangements. If the sales volumes of products subject to such
arrangements are not sufficient to recover such royalty advances and guarantees,
the Company would be required to write-off unrecovered portions of such
payments, which could have a material adverse effect on its business, operating
results and financial condition. Further, there can be no assurance that third
party developers will not demand renegotiation of their arrangements with the
Company.
Rapidly Changing Technology; Platform Risks
The interactive entertainment software industry is subject to rapid
technological change. The introduction of new technologies, including operating
systems such as Microsoft Windows 95 and 98, technologies that support multi-
player games, new media formats such as on-line delivery and digital video disks
("DVDs") and as yet unreleased video game platforms could render the Company's
current products or products in development obsolete or unmarketable. The
Company must continually anticipate and assess the emergence of, and market
acceptance of, new interactive entertainment software platforms well in advance
of the time the platform is introduced to consumers. Because product
development cycles are difficult to predict, the Company is required to make
substantial product development and other investments in a particular platform
well in advance of introduction of the platform. If the platforms for which the
Company develops software are not released on a timely basis or do not attain
significant market penetration, the Company's business, operating results and
financial condition could be materially adversely affected. Alternatively, if
the Company fails to develop products for a platform that does achieve
significant market penetration, then the Company's business, operating results
and financial condition could also be materially adversely affected.
The emergence of new interactive entertainment software platforms and
technologies and the increased popularity of new products and technologies may
materially and adversely affect the demand for products based on older
technologies. In this regard, the Company's results of operations in its former
fiscal year ended April 30, 1997 were adversely affected by a sharp decline in
the market for titles for the Macintosh and Sega Saturn platforms, which
declines resulted in a high level of product returns and markdown allowances.
The broad range of competing and incompatible emerging technologies may lead
consumers to postpone buying decisions with respect to products until one or
more of such technologies gain widespread acceptance. Such postponement could
have a material adverse effect on the Company's business, operating results and
financial condition. The Company is currently actively developing products for
the Microsoft Windows 95 and 98, PlayStation(R) and Nintendo 64 platforms. The
Company's success will depend in part on its ability to anticipate technological
changes and to adapt its products to emerging game platforms. There can be no
assurance that the Company will be able to anticipate future technological
changes, to obtain licenses to develop products for those platforms on terms
favorable to the Company or to create software for those new platforms, and any
failure to do so could have a material adverse effect on the Company's business,
operating results and financial condition.
Industry Competition; Competition for Shelf Space
The interactive entertainment software industry is intensely competitive and
is characterized by the frequent introduction of new interactive entertainment
software platforms and software platforms. The Company's competitors vary in
size from small companies to very large corporations with significantly greater
financial, marketing and product development resources than those of the
Company. Due to
22
these greater resources, certain of the Company's competitors are able to
undertake more extensive marketing campaigns, adopt more aggressive pricing
policies, pay higher fees to licensors of desirable motion picture, television,
sports and character properties and pay more to third party software developers
than the Company. The Company believes that the principal competitive factors in
the interactive entertainment software industry include product features, brand
name recognition, access to distribution channels, quality, ease of use, price,
marketing support and quality of customer service.
The Company competes primarily with other publishers of PC and video game
console interactive entertainment software. Significant competitors include
Electronic Arts, GT Interactive Software Corp., Cendant Corporation, Activision,
Inc., Microsoft Corporation, LucasArts Entertainment Company, Midway Games Inc.,
Acclaim Entertainment Inc., and Hasbro Inc. In addition, integrated video game
console hardware/software companies such as Sony Computer Entertainment,
Nintendo and Sega compete directly with the Company in the development of
software titles for their respective platforms. Large diversified entertainment
companies, such as The Walt Disney Company, many of which own substantial
libraries of available content and have substantially greater financial
resources than the Company, may decide to compete directly with the Company or
to enter into exclusive relationships with competitors of the Company. The
Company also believes that the overall growth in the use of the Internet and on-
line services by consumers may pose a competitive threat if customers and
potential customers spend less of their available home PC time using interactive
entertainment software and more on the Internet and on-line services.
Retailers of the Company's products typically have a limited amount of shelf
space and promotional resources, and there is intense competition among consumer
software producers, and in particular interactive entertainment software
products, for high quality retail shelf space and promotional support from
retailers. To the extent that the number of consumer software products and
computer platforms increases, competition for shelf space may intensify and may
require the Company to increase its marketing expenditures. Due to increased
competition for limited shelf space, retailers and distributors are in an
increasingly better position to negotiate favorable terms of sale, including
price discounts, price protection, marketing and display fees and product return
policies. The Company's products constitute a relatively small percentage of
any retailer's sale volume, and there can be no assurance that retailers will
continue to purchase the Company's products or to provide the Company's products
with adequate levels of shelf space and promotional support, and a prolonged
failure in this regard may have a material adverse effect on the Company's
business, operating results and financial condition.
Dependence Upon Third Party Licenses
Many of the Company's products, such as its Star Trek, Major League Baseball
and Caesars Palace titles, are based on original ideas or intellectual
properties licensed from third parties. There can be no assurance that the
Company will be able to obtain new licenses, or renew existing licenses, on
commercially reasonable terms, if at all. For example, Paramount has granted
the Star Trek license to a third party upon the expiration of the Company's
rights. Should the Company be unable to obtain licenses for the underlying
content that it believes offers the greatest consumer appeal, the Company would
either have to seek alternative, potentially less appealing licenses, or release
the products without the desired underlying content, either of which events
could have a material adverse effect on the Company's business, operating
results and financial condition. There can be no assurance that acquired
properties will enhance the market acceptance of the Company's products based on
such properties, that the Company's new product offerings will generate net
revenues in excess of their costs of development and marketing or minimum
royalty obligations, or that net revenues from new product sales will meet or
exceed net revenues from existing product sales.
Dependence on Distribution Channels; Risk of Customer Business Failures; Product
Returns
23
The Company currently sells its products directly through its own sales force
to mass merchants, warehouse club stores, large computer and software specialty
chains and through catalogs in the U.S. and Canada, as well as to certain
distributors. Outside North America, the Company generally sells to third party
distributors. The Company's sales are made primarily on a purchase order basis,
without long-term agreements. The loss of, or significant reduction in sales
to, any of the Company's principal retail customers or distributors could
materially adversely affect the Company's business, operating results and
financial condition.
The distribution channels through which consumer software products are sold
are characterized by continuous change, including consolidation, financial
difficulties of certain distributors and retailers, and the emergence of new
distributors and new retailers such as warehouse chains, mass merchants and
computer superstores. As more consumers own PCs, the distribution channels for
interactive entertainment software have changed are expected to continue to
change. Mass merchants have become the most important distribution channels for
retail sales of interactive entertainment software. A number of these mass
merchants, including Wal-Mart, have entered into exclusive buying arrangements
with other software developers or distributors, which arrangements prevent the
Company from selling certain of its products directly to that mass merchant. If
the number of mass merchants entering into exclusive buying arrangements with
software distributors other than the Company were to increase, the Company's
ability to sell to such merchants would be restricted to selling through the
exclusive distributor. Because sales to distributors typically have a lower
gross profit than sales to retailers, this would have the effect of lowering the
Company's gross profit. In addition, this trend could increase the material
adverse impact on the Company's business, operating results and financial
condition. In addition, emerging methods of distribution, such as the Internet
and on-line services, may become more important in the future, and it will be
important for the Company to maintain access to these channels of distribution.
There can be no assurance that the Company will maintain such access or that the
Company's access will allow the Company to maintain its historical levels of
sales volume.
Distributors and retailers in the computer industry have from time to time
experienced significant fluctuations in their businesses, and there have been a
number of business failures among these entities. The insolvency or business
failure of any significant distributor or retailer of the Company's products
could have a material adverse effect on the Company's business, operating
results and financial condition. Sales are typically made on unsecured credit,
with terms that vary depending upon the customer and the nature of the product.
Although the Company has obtained insolvency risk insurance to protect against
any bankruptcy, insolvency or liquidation that may occur involving its
customers, such insurance contains a significant deductible and a co-payment
obligation, and the policy does not cover all instances of non-payment. In
addition, while the Company maintains a reserve for uncollectible receivables,
the actual reserve may not be sufficient in every circumstance. As a result, a
payment default by a significant customer could have a material adverse effect
on the Company's business, operating results and financial condition.
Dependence on Licenses from and Manufacturing by Hardware Companies
The Company is required to obtain a license to develop and distribute software
for each of the video game console platforms for which the Company develops
products, including a separate license for each of North America, Japan and
Europe. The Company has obtained licenses to develop software for the
PlayStation in North America and Japan and is currently negotiating agreements
covering additional territories. In addition, the Company has obtained a
license to develop software for the Nintendo 64 in North America and is
currently negotiating with Nintendo for licenses covering additional
territories. There can be no assurance that the Company will be able to obtain
licenses from hardware companies on acceptable terms or that any existing or
future licenses will be renewed by the licensors. In addition, each of Sony
Computer Entertainment, Nintendo and Sega have the right to approve the
technical
24
functionality and content of the Company's products for such platform
prior to distribution. Due to the nature of the approval process, the Company
must make significant product development expenditures on a particular product
prior to the time it seeks such approvals. The inability of the Company to
obtain such approvals could have a material adverse effect on the Company's
business, operating results and financial condition.
Hardware companies such as Sony Computer Entertainment, Nintendo and Sega may
impose upon their licensees a restrictive selection and product approval
process, such that licensees are restricted in the number of titles that will be
approved for distribution on the particular platform. While the Company has
prepared its future product release plans taking this competitive approval
process into consideration, if the Company has incorrectly predicted the impact
of this restrictive approval process, and as a result the Company fails to
obtain approvals for all products in the Company's development plans, such
failure could have a material adverse effect on the Company's business,
operating results and financial condition. The Company depends upon Sony
Computer Entertainment and Nintendo for the manufacture of the Company's
products that are compatible with their respective video game consoles. As a
result, Sony and Nintendo have the ability to raise prices for supplying such
products at any time and effectively control the timing of the Company's release
of new titles for those platforms. PlayStation products consist of CD-ROMs and
are typically delivered by Sony Computer Entertainment within a relatively short
lead time. Manufacturers of Nintendo and other video game cartridges typically
deliver software to the Company within 45 to 60 days after receipt of a purchase
order. If the Company experiences unanticipated delays in the delivery of
video game console products from Sony Computer Entertainment or Nintendo, or if
actual retailer and consumer demand for its interactive entertainment software
differs from that forecast by the Company, its business, operating results and
financial condition could be materially adversely affected.
Dependence on Key Personnel
The Company's success depends to a significant extent on the continued service
of it key product design, development, sales, marketing and management
personnel, and in particular on the leadership, strategic vision and industry
reputation of its founder and Chief Executive Officer, Brian Fargo. The
Company's future success will also depend upon the Company's ability to continue
to attract, motivate and retain highly qualified employees and contractors,
particularly key software design and development personnel. Competition for
highly skilled employees is intense, and there can be no assurance that the
Company will be successful in attracting and retaining such personnel.
Specifically, the Company may experience increased costs in order to attract and
retain skilled employees. The Company's failure to retain the services of Brian
Fargo or its other key personnel or to attract and retain additional qualified
employees could have a material adverse effect on the Company's business,
operating results and financial condition.
Risks Associated with International Operations; Currency Fluctuations
International net revenues accounted for 26.7% and 28.7% of the Company's
total net revenues in the nine months ended September 30, 1998 and the three
months ended September 30, 1998, respectively. The Company intends to continue
to expand its direct and indirect sales, marketing and product localization
activities worldwide. Such expansion will require significant management time
and attention and financial resources in order to develop improved international
sales and support channels. There can be no assurance, however, that the
Company will be able to maintain or increase international market demand for its
products. International sales and operations are subject to a number of
inherent risks, including the impact of possible recessionary environments in
economies outside the U.S., the time and financial costs associated with
translating and localizing products for foreign markets, longer accounts
receivable collection periods and greater difficulty in accounts receivable
collection, unexpected changes in regulatory requirements, difficulties and
costs of staffing and managing foreign
25
operations, and political and economic instability. For example, the Company has
recently experienced difficulties selling products in certain Asian countries as
a result of economic instability in such countries, and there can be no
assurance that such difficulties will not continue or occur in other countries
in the future. There can be no assurance that the foregoing factors will not
have a material adverse effect on the Company's future international net
revenues and, consequently, on the Company's business, operating results and
financial condition. The Company currently does not engage in currency hedging
activities. Although exposure to currency fluctuations to date has been
insignificant, there can be no assurance that fluctuations in currency exchange
rates in the future will not have a material adverse effect on net revenues from
international sales and licensing, and thus on the Company's business, operating
results and financial condition.
Risks Associated with New European Currency
On January 1, 1999, eleven of the fifteen member countries of the European
Union ("Participating Countries") are scheduled to establish fixed conversion
rates between their existing sovereign currencies and a new European currency,
the "euro". The euro will be adopted by the Participating Countries as the
common legal currency on that date. A significant portion of the Company's sales
are made to Participating Countries and consequently, the Company anticipates
that the euro conversion will, among other things, create technical challenges
to adapt information technology and other systems to accommodate euro-
denominated transactions and limit the Company's ability to charge different
prices for its producers in different markets. While the Company anticipates
that the conversion will not cause material disruption of its business, there
can be no assurance that the conversion will not have a material effect on the
Company's business or financial condition.
Management of Growth
The Company has in the past undergone a period of rapid growth that has placed
a significant strain on the Company's financial, management and other resources.
The Company's ability to manage its growth effectively, should it continue, will
require it to continue to improve its operational, financial and management
information systems and to attract, train, motivate, manage and retain key
employees. If the Company's executives are unable to manage growth effectively,
the Company's business, operating results and financial condition could be
materially adversely affected.
Protection of Proprietary Rights
The Company regards its software as proprietary and relies on a combination of
copyright, trademark and trade secret laws, employee and third party
nondisclosure agreements and other methods to protect its proprietary rights.
The Company owns or licenses various copyrights and trademarks. While the
Company provides "shrinkwrap" license agreements or limitations on use with its
software, the enforceability of such agreements or limitations is uncertain.
The Company is aware that unauthorized copying occurs within the computer
software industry, and if a significantly greater amount of unauthorized copying
of the Company's interactive entertainment software products were to occur, the
Company's operating results could be materially adversely affected. While the
Company does not copy protect its products, it does not provide source code to
third parties unless they have signed nondisclosure agreements with respect
thereto.
The Company relies on existing copyright laws to prevent unauthorized
distribution of its software. Existing copyright laws afford only limited
protection. Policing unauthorized use of the Company's products is difficult,
and software piracy can be expected to be a persistent problem, especially in
certain international markets. Further, the laws of certain countries in which
the Company's products are or may be distributed either do not protect the
Company's products and intellectual property rights to the same extent as the
laws of the U.S. or are weakly enforced. Legal protection of the Company's
rights may be ineffective in such counties, and as the Company leverages its
software products using emerging technologies, such as the Internet and on-line
services, the ability of the Company to protect its intellectual property
rights, and to avoid infringing the intellectual property rights of others,
becomes
26
more difficult. There can be no assurance that existing intellectual
property laws will provide adequate protection to the Company's products in
connection with such emerging technologies.
As the number of interactive entertainment software products in the industry
increases and the features and content of these products further overlap,
software developers may increasingly become subject to infringement claims.
Although the Company makes reasonable efforts to ensure that its products do not
violate the intellectual property rights of others, there can be no assurance
that claims of infringement will not be made. Any such claims, with or without
merit, can be time consuming and expensive to defend. From time to time, the
Company has received communications from third parties of such parties. There
can be no assurance that existing or future infringement claims against the
Company will not result in costly litigation or require the Company to license
the intellectual property rights of third parties, either of which could have a
material adverse effect on the Company's business, operating results and
financial condition.
Entertainment Software Rating System; Governmental Restrictions
Legislation is periodically introduced at the state and federal levels in the
U.S. and in foreign countries to establish a system for providing consumers with
information about graphic violence and sexually explicit material contained in
interactive entertainment software products. Such a system would include
procedures with which interactive entertainment software publishers would be
expected to comply by identifying particular products within defined rating
categories and communicating such ratings to consumers through appropriate
package labeling and through advertising and marketing presentations consistent
with each products' rating. In addition, many foreign countries have laws which
permit governmental entities to censor the content of certain works, including
interactive entertainment software. In certain instances, the Company may be
required to modify its products to comply with the requirements of such
governmental entities, which could delay the release of those products in such
countries. Such delays could have a material adverse effect on the Company's
business, operating results and financial condition. While the Company
currently voluntarily submits its products to industry-created review boards and
publishes their ratings on its game packaging, the Company believes that
mandatory government-run integrative entertainment software products rating
systems eventually will be adopted in many countries which represent significant
markets or potential markets for the Company. Due to the uncertainties inherent
in the implementation of such a rating system, confusion in the marketplace may
occur, and the Company is unable to predict what effect, if any, such a rating
system would have on the Company's business. In addition to such regulations,
certain retailers have in the past declined to stock certain of the Company's
products because they believed that the content of the packaging artwork or the
products would be offensive to the retailer's customer base. While to date such
actions have not had a material adverse effect on the Company's business,
operating results or financial condition, there can be no assurance that similar
actions by the Company's distributors or retailers in the future would not have
a material adverse effect on the Company's business, operating results and
financial condition.
Development of Internet/On-Line Services or Products
The Company seeks to establish an on-line presence by creating and supporting
sites on the Internet. The Company's future plans envision conducting and
supporting on-line product offerings through these sites or others. The ability
of the Company to successfully establish an on-line presence and to offer on-
line products will depend on several factors that are outside the Company's
control, including the emergence of a robust on-line industry and infrastructure
and the development and implementation of technological advancements to the
Internet to increase bandwidth and the speed of responsiveness to the point that
will allow the Company to conduct and support on-line product offerings.
Because global commerce and the exchange of information on the Internet and
other similar open, wide area networks are relatively new and evolving, there
can be no assurance that a viable
27
commercial marketplace on the Internet will emerge from the developing industry
infrastructure, that the appropriate complementary products for providing and
carrying Internet traffic and commerce will be developed, that the Company will
be able to create or develop a sustainable or profitable on-line presence or
that the Company will be able to generate any significant revenue from On-Line
product offerings in the near future, it at all. If the Internet does not become
a viable commercial marketplace, or if such development occurs but is
insufficient to meet the Company's needs or if such development is delayed
beyond the point where the Company plans to have established an On-Line service,
the Company's business, operating results and financial condition could be
materially adversely affected.
Year 2000 Issue
Many existing computer systems and applications, and other control devices,
use only two digits to identify a year in the date field, without considering
the impact of the upcoming change in the century. Therefore, they do not
properly recognize a year that begins with "20" rather than "19". Others do not
correctly process "leap year" dates. As a result, such systems and applications
could fail or create erroneous results unless corrected so that they can
correctly process data related to the Year 2000 and beyond. The Company relies
on its systems and applications in operating and monitoring all major aspects of
its business, including financial systems (such as general ledger, accounts
payable and payroll modules), customer services, networks and telecommunications
systems equipment and end products. The Company also relies, directly and
indirectly, on external systems of suppliers for the management and control of
product development and of business enterprises such as developers, customers,
suppliers, creditors, financial organizations, and governmental entities, both
domestic and international, for accurate exchange of data. The Company could be
affected through disruptions in the operation of the enterprises with which the
Company interacts or from general widespread problems or an economic crisis
resulting from noncompliant Year 2000 systems. Despite the Company's efforts to
address the Year 2000 impact on its internal systems and business operations,
there can be no assurance that such impact will not result in a material
disruption of its business or have a material adverse effect on the Company's
business, operating results and financial condition.
The Company is currently in the process of assessing the potential impact of
the Year 2000 issue on its business and the related foreseeable expenses that
may be incurred in attempting to remedy such impact. The Company is employing a
combination of internal resources and outside consultants to evaluate and
address Year 2000 issues. The Company's Year 2000 plan includes (i) conducting
an evaluation of the Company's computer based systems, facilities and products
(and those of significant dealers, vendors and other third parties with which
the Company does business) to determine their Year 2000 compliance, (ii)
coordinating the replacement and/or upgrade of non-compliant systems, as
necessary, and (iii) developing and overseeing the implementation of all of the
initiatives in the Company's Year 2000 compliance plan. For example, the Company
is in the process of upgrading its internal accounting software and expects such
upgrade to be complete prior to the Year 2000. Although the Company has
identified certain systems and applications that are not Year 2000 compliant and
the Company is in the process of upgrading its software to address the Year 2000
issue, there can be no assurance that such upgrades will be completed on a
timely basis at reasonable costs, or that such upgrades will be able to
anticipate all of the problems triggered by the actual impact of the Year 2000.
In addition, the inability of any internal system to achieve Year 2000
compliance could result in material disruption to the Company's operations. With
respect to customers, developers, suppliers and other enterprises upon which the
Company relies, even where assurances are received from such third parties,
there remains a risk that failure of systems and applications of such third
parties could have a material adverse effect on the Company.
The Company is currently assessing its products for Year 2000 compliance and
anticipates such assessment to be complete prior to the Year 2000. The Company
expects to correct and make available through its customer service organization
upgrades or patches for those of its products that are found not to be Year 2000
compliant. However, there can be no assurance that any of the Company's
products are or will be Year 2000 compliant or that the Company will complete
any upgrades or patches which may
28
be necessary. The failure of any of the Company's products to achieve Year 2000
compliance would result in increased warranty costs, customer satisfaction
issues, potential lawsuits and other material costs and liabilities. In
addition, if the computer systems on which the consumers use the Company's
products are not Year 2000 compliant, such non compliance could adversely affect
the consumers ability to use such products.
The Company believes that it will substantially complete the implementation of
its Year 2000 plan prior to the commencement of the Year 2000. However, if the
Company does not complete its Year 2000 plan prior to the commencement of the
Year 2000, or if the Company fails to identify and remediate all critical Year
2000 problems or if major suppliers, developers or customers experience material
Year 2000 problems, the Company's results of operations or financial condition
could be materially adversely effected.
The Company's current estimate is that the costs associated with the Year 2000
issue should not have a material adverse effect on the results of operations or
financial position of the Company in any given year. The Company has not yet
developed Year 2000 non-compliance contingency plans, but will consider the need
for such plans upon completion of the Year 2000 compliance assessments.
The foregoing statements are based upon management's best estimates at the
present time, which were derived utilizing numerous assumptions of future
events, including the continued availability of certain resources, third party
modification plans and other factors. There can be no assurance that these
estimates will be achieved and actual results could differ materially from those
anticipated. Specific factors that might cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in this area, the ability to locate and correct all relevant computer codes, the
nature and amount of programming required to upgrade or replace each of the
affected programs, the rate and magnitude of related labor and consulting costs
and the success of the Company's external customers, developers and suppliers in
addressing the Year 2000 issue. The Company's evaluation is ongoing and it
expects that new and different information will become available to it as the
evaluation continues. Consequently, there can be no assurance that all material
elements will be Year 2000 compliant in time.
Risks Associated with Acquisitions
As part of its strategy to enhance distribution and product development
capabilities, the Company intends to review potential acquisitions of
complementary businesses, products and technologies. Some of these acquisitions
could be material in size and scope. While the Company will continue to search
for appropriate acquisition opportunities, there can be no assurance that the
Company will be successful in identifying suitable acquisition opportunities. If
any potential acquisition opportunity is identified, there can be no assurance
that the Company will consummate such acquisition, and if such acquisition does
occur, there can be no assurance that it will be successful in enhancing the
Company's business or will be accretive to the Company's earnings. As the
interactive entertainment software industry continues to consolidate, the
Company may face increased competition for acquisition opportunities, which may
inhibit its ability to complete suitable transactions or increase the cost
thereof. Future acquisitions could also divert substantial management time,
could result in short term reductions in earnings or special transaction or
other charges and may be difficult to integrate with existing operations or
assets.
The Company may, in the future, issue additional shares of Common Stock in
connection with one or more acquisitions, which may dilute its stockholders,
including investors in the IPO. Additionally, with respect to future
acquisitions, the Company's stockholders may not have an opportunity to review
the financial statements of the entity being acquired or to vote on such
acquisitions.
Control by Directors and Officers
29
The Company's directors and officers and Universal Studios, Inc.
("Universal"), which currently has two representatives on the Company's Board of
Directors, in the aggregate, beneficially own approximately 58.4% of the
Company's outstanding Common Stock (excluding outstanding options). These
stockholders, if acting together, would be able to control substantially all
matters requiring approval by the stockholders of the Company, including the
election of directors (subject to the cumulative voting rights of the Company's
stockholders) and the approval of mergers or other business combination
transactions. Such concentration of ownership could discourage or prevent a
change in control of the Company.
Anti-Takeover Effects; Delaware Law and Certain Charter and Bylaw Provisions
The Company's Certificate of Incorporation and Bylaws, as well as Delaware
corporate law, contain certain provisions that could have the effect of
delaying, deferring or preventing a change in control of the Company and could
materially adversely affect the prevailing market price of the Common Stock.
Certain of such provisions impose various procedural and other requirements that
could make it more difficult for stockholders to effect certain corporate
actions.
Stock Price Volatility
The trading price of the Company's Common Stock has been and could continue to
be subject to wide fluctuations in response to quarter to quarter variations in
results of operations, announcements of new products by the Company or its
competitors, product development or release schedule, general conditions in the
computer, software, entertainment, media or electronics industries, changes in
earnings estimates or buy/sell recommendations by analysts, investor perceptions
and expectations regarding the products, plans and strategic position of the
Company, its competitors and its customers, or other events or factors. In
addition, the public stock markets have experienced extreme price and trading
volume volatility, particularly in high technology sectors of the market. This
volatility has significantly affected the market prices of securities of many
technology companies for reasons frequently unrelated to the operating
performance of the specific companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.
30
PART II. Other Information
Item 1. Legal Proceedings
-----------------
The Company is involved in various legal proceedings, claims and litigation
arising in the ordinary course of business, including disputes arising over the
ownership of intellectual property rights and collection matters. In the
opinion of management, the outcome of such routine claims will not have a
material adverse effect on the Company's business, financial condition or
results of operations.
Item 2. Exhibits and Reports on Form 8-K
--------------------------------
(a) Exhibits - The following exhibits are filed as part of this report:
--------
Exhibit
Number Exhibit Title Page
------- ------------- ----
10.1 Fourth Amendment to Von Karman Corporate Center
Office Building Lease, dated July 29, 1998,
between the Company and Arden Realty Finance IV,
L.L.C., as successor-in-interest to Aetna Life
Insurance Company of Illinois. _____
10.2 Schedules 8 through 10 to the Master Equipment
Lease between Brentwood Credit Corporation and
the Company dated March 28, 1996, filed as
Exhibit 10.20 to the Registration Statement on
Form S-1, File No. 333-48473. _____
27.1 Financial data schedule for the nine month period
ended September 30, 1998. _____
(b) Reports on Form 8-K
-------------------
A Report on Form 8-K was filed by the Company on October 2, 1998
reporting that on September 25, 1998, the Company announced that it had accepted
the resignation of David Dukes as a director of the Company.
31
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTERPLAY ENTERTAINMENT
CORP.
Date: November 23, 1998 By: /s/ James C. Wilson
-------------------
James C. Wilson,
Chief Financial Officer
(Principal Financial and Accounting
Officer and Duly Authorized
Officer)
32
EXHIBIT INDEX
Exhibit
Number Exhibit Title Page
- ------- ------------- ----
10.1 Fourth Amendment to Von Karman Corporate Center
Office Building Lease, dated July 29, 1998,
between the Company and Arden Realty Finance IV,
L.L.C., as successor-in-interest to Aetna Life
Insurance Company of Illinois. _____
10.2 Schedules 8 through 10 to the Master Equipment
Lease between Brentwood Credit Corporation and
the Company, dated March 28, 1996, filed as
Exhibit 10.20 to the Registration Statement on
Form S-1, File No. 333-48473. _____
27.1 Financial data schedule for the nine month period
ended September 30, 1998. _____
33